Adjustable Rate Mortgages (ARM)
Adjustable Rate Mortgages (ARM)s are loans whose interest rate can vary during the loan's term. These loans usually have a fixed interest rate for an initial period of time and then can adjust based on current market conditions. The initial rate on an ARM is lower than on a fixed rate mortgage which allows you to afford and hence purchase a more expensive home. Adjustable rate mortgages are usually amortized over a period of 30 years with the initial rate being fixed for anywhere from 1 month to 10 years. All ARM loans have a "margin" plus an "index." Margins on loans range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value. The index is the financial instrument that the ARM loan is tied to such as: 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI).
When the time comes for the ARM to adjust, the margin will be added to the index and typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will then be fixed for the next adjustment period. This adjustment can occur every year, but there are factors limiting how much the rates can adjust. These factors are called "caps". Suppose you had a "3/1 ARM" with an initial cap of 2%, a lifetime cap of 6%, and initial interest rate of 6.25%. The highest rate you could have in the fourth year would be 8.25%, and the highest rate you could have during the life of the loan would be 12.25%.
Some ARM loans have a conversion feature that would allow you to convert the loan from an adjustable rate to a fixed rate. There is a minimal charge to convert; however, the conversion rate is usually slightly higher than the market rate that the lender could provide you at that time by refinancing.
Components of Adjustable Rate Mortgages
To understand an ARM, you must have a working knowledge of its components. Those components are:
Index: A financial indicator that rises and falls, based primarily on economic fluctuations. It is usually an indicator and is therefore the basis of all future interest adjustments on the loan. Mortgage lenders currently use a variety of indexes.
Margin: A lender's loan cost plus profit. The margin is added to the index to determine the interest rate because the index is the cost of funds and the margin is the lender's cost of doing business plus profit.
Initial Interest: The rate during the initial period of the loan, which is sometimes lower than the note rate. This initial interest may be a teaser rate, an unusually low rate to entice buyers and allow them to more readily qualify for the loan.
Note Rate: The actual interest rate charged for a particular loan program.
Adjustment Period: The interval at which the interest is scheduled to change during the life of the loan (e.g. annually).
Interest Rate Caps: Limit placed on the up-and-down movement of the interest rate, specified per period adjustment and lifetime adjustment (e.g. a cap of 2 and 6 means 2% interest increase maximum per adjustment with a 6% interest increase maximum over the life of the loan).
Negative Amortization: Occurs when a payment is insufficient to cover the interest on a loan. The shortfall amount is added back onto the principal balance.
Convertibility: The option to change from an ARM to a fixed-rate loan. A conversion fee may be charged.
Carryover: Interest rate increases in excess of the amount allowed by the caps that can be applied at later interest rate adjustments (a component that most newer ARMs are deleting).